Key Principle No. 2

“Margin of safety” is an attitude, not a calculation.

Buying stocks that have a “margin of safety” is the only way to invest. Everything else is speculation. Since Graham wrote about this concept many years ago, it has been open to a wide variety of interpretations.

There is no single calculation, or group of calculations, that can be done to see if a particular stock has a margin of safety. Qualitative factors are just as important as quantitative factors. Valuation is an important part of the evaluation of margin of safety, but other factors are involved.

When you first start evaluating a stock the first questions must be:

What limits my downside risk if I buy the stock at this price?

Only after successfully answering this question can the analyst begin to evaluate the potential return from investing in a stock. It is this “risk first” attitude that defines real margin of safety analysis.

In some cases ratios like price/book and price/EV are good indicators a margin of safety is present, however in other cases these ratios are utterly worthless. Comparing current valuations to prices paid by savvy investors for similar assets is another way to estimate a margin of safety, but the application of this method can be tricky. Margin of safety must be evaluated on a case by case basis.

Every stock we select for our model portfolio will have a clearly established margin of safety.